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Alternatives to Money Funds

BlackRock and Legg Mason launch new bond funds designed to work like money funds, but with very short maturities and a floating NAV.

BlackRock Inc. and Western Asset Management Co. are offering a new twist on traditional money-market funds as regulators are set to impose sweeping changes on the $2.58 trillion industry.

BlackRock, the world’s biggest money manager, and Legg Mason Inc.’s Western Asset unit have started bond funds designed to work much like money funds, with a key difference. The new “ultra-short” funds have share prices that fluctuate along with the value of their holdings, rather than a fixed net asset value, or NAV, a distinguishing feature of money funds. They also have shorter maturities than similar ultra-short bond funds that ran into trouble when credit markets froze in 2008.

The firms are preparing for what could be a seismic reallocation of assets by institutional investors and corporate treasurers if regulators overhaul money funds for a second time in three years in a bid to make them safer after the 2008 collapse of the Reserve Primary Fund. The U.S. Securities and Exchange Commission plans to order a floating NAV on institutional prime money-market funds, or those that invest in corporate debt, overriding opposition from the industry.

“We would expect to see more corporations use more vehicles than are used today once we get to a floating NAV for prime money-market funds,” said Richard Hoerner, head of New York-based BlackRock’s global cash-management business. “The fund is designed for short-term investors seeking to outperform money-market funds, with potential returns that exceed those of prime money-market funds under normal market conditions.”

Mary Athridge, a spokeswoman for Baltimore-based Legg Mason, declined to comment on the Western Asset Ultra Short Obligations Fund, which the firm filed to register on May 8. BlackRock opened the BlackRock Ultra-Short Obligations Fund in November, and it has about $25 million of assets.

The new funds are different from existing U.S. ultra-short bond funds, which had $280.1 billion of assets at the end of last year, according to iMoneyNet, a Westborough, Massachusetts-based provider of money-market research and analysis. The funds, run by companies ranging from Pittsburgh-based Federated Investors Inc. to Boston-based Fidelity Investment, generally hold investment-grade debt that matures in one to two years, according to a review of regulatory filings.

The BlackRock and Western Asset funds have shorter maturities and can only invest in high-quality debt. Some short-term bond funds that were touted as higher-yielding alternatives to money funds faced severe losses in 2008 as they held debt tied to mortgages. State Street Corp.’s SSgA Yield Plus Fund fell 19 percent in the first five months of 2008 before being liquidated. Charles Schwab Corp.’s YieldPlus fund fell to $1.8 billion in assets in 2008 from a peak of $13.5 billion in 2007, after it invested more than 25 percent of fund assets in private issuer mortgage-backed securities.

The BlackRock and Western Asset ultra-short bond funds have both pledged to limit the average maturity of their portfolios to no more than 90 days. That was the legal threshold for money-market funds until 2010, when the SEC lowered the ceiling to 60 days as part of an earlier effort designed to reduce systemic risk. As with money funds, the BlackRock and Western products will primarily hold debt securities that mature in 397 days or less.

‘Reshaping’ Industry

Money-market funds are allowed to use an accounting method that produces a stable net asset value of $1 a share under Rule 2a-7 of the Investment Company Act of 1940. Investment earnings, rather than lifting the share price, are distributed in cash or new shares. This feature has made money-market funds a favorite among individuals, institutional investors, and corporations who want a place to park their cash that will provide a higher return than those typically paid on bank deposits.

Federal regulators have been searching for ways to prevent a replay of September 2008, when the $62.5 billion Reserve Primary Fund “broke the buck,” or fell below the $1 NAV. The collapse triggered a wider run on money funds that contributed to a freeze in the global credit markets. In 2010, the SEC tightened rules on credit quality, shortened the maximum average maturity for funds and introduced minimum liquidity levels. Mary Schapiro, then the SEC’s chairman, called that a first step toward making money funds more stable and pushed a plan to make funds abandon their $1 share price or build capital reserves.

The industry, led by providers including Fidelity Investments and Federated Investors, fought back against proposals and sought to limit the scope of changes. The SEC is now planning a narrower proposal that requires the use of floating net asset values by institutional money-market funds that invest in corporate debt, a person familiar with the matter said last week. Such a change would apply to funds managing $950 billion, or about 37 percent of U.S. money-fund assets, according to iMoneyNet.

The regulatory changes could lead to a “reshaping” of the money-market industry, including changes to the “overall liquidity product landscape,” Moody’s Investors Service said in a May 13 report. One possible consequence would be growth in alternative cash products, including short-duration bond funds, developed by large money-market fund managers to offset the “expected loss” of assets in prime funds hit by the new rule, the report said.

A lot of the innovation “has been held in abeyance waiting for the SEC,” Geoff Bobroff, a mutual-fund consultant in East Greenwich, Rhode Island, said in an interview. “People are starting to gear up” now that the SEC appears ready to act, Bobroff said.

Credit Quality

The BlackRock and Western Asset funds expect to invest at least 25 percent of their assets in securities issued by companies in the financial services sector, such as banks and brokerages.

In terms of credit quality, BlackRock and Western will only invest in fixed-income securities that have either the top or second-best short-term debt rating from credit-raters such as Moody’s or Standard & Poor’s. While the BlackRock fund can have any amount of assets in the second-highest category, the Western Asset fund must invest at least 95 percent of its assets in debt with the top-tiered rating, the prior standard for money-market funds until the SEC raised it by two percentage points to 97 percent in 2010.

“It sounds like a turbo-charged money-market fund,” said Steven Shachat, a senior portfolio manager at Alpine Woods Capital Investors LLC in Purchase, New York. “It appears as if we might be heading in the direction of a floating NAV anyway, so they are just heading this off at the pass.”

BlackRock’s Hoerner said the new ultra-short fund is “clearly” not a money-market fund, though at first glance it may “look similar” to one. In addition to the floating net asset value, Hoerner cited several other differences, such as the 2010 revisions to Rule 2a-7 require money-market funds to keep 30 percent of their assets in securities that mature within seven days. Neither the Western Asset nor the BlackRock ultra- short fund have such a provision.

The stable $1 value is one of the main appeals of money funds as investors seek the preservation of their capital amid record-low interest rates. Corporate money-market clients would be reluctant to give up the benefits of a stable net asset value for a slightly higher yield, said Shachat at Alpine Woods. “A lot of the major corporations are just so risk-averse,” Shachat said. “That is why you see Treasury funds with hundreds of billions of dollars basically earning zero.”

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